checklist34 (99.59)

Help a fool out: how can one hedge or lock interest rates?

9

I have this situation and I'm trying to wrap my brain around it. I am elligible for a line of credit (not a loan, no amortization is requisite) via the institution that holds much of my investments (stocks etc.) at libor plus.

So basically the one month libor rate + a little bit more would be the interest rate. Libor right now is basically zero and the resulting interest rate is ubelievably attractive. And I would like to take this line of credit and use it for several purposes... It will take time to deploy the funds, but i'm willing to pay interest on the whole amount to lock in current rates... if locking in those rates is possible.

But I don't want my interest rate skyrocket if libor moves from basically zero (0.29% right now) to 5% or something.

So I would like to hedge interest rates, but I have absolutely no idea how to do it.

Can I go long on Libor? Or libor futures or something? So say I borrow 1000 bucks under my line of credit, and say I'dthen have to pay 20=30 bucks a year in interest on it. But if libor goes to 10% then I'm paying 12% and happy becomes sad. But say I was long libor with 100 bucks. At 0.29%. And it went to 10% would I then have 3000 bucks?

Interest rate swaps would be the way institutions would do it. You would enter an agreement with a counter party where you pay a fixed rate, receive a floating rate. These swaps are typically based off LIBOR. I don't know if there are ways an individual investor can enter into a swap, but would be worth looking into.

Well, if your line of credit is stuck to LIBOR, then you should use something like Eurodollar futures.

Eurodollars are US dollars held outside of the US (usually in Europe, hence their name), and earn interest tied to LIBOR, and the Eurodollar futures settle based on LIBOR. A quick Google on it should give you the idea.

The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at the Chicago Mercantile Exchange (CME) in Chicago. Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future.[3] Each CME Eurodollar futures contract has a notional or "face value" of $1,000,000, though the leverage used in futures allows one contract to be traded with a margin of about one thousand dollars. Trading in Eurodollar futures is extensive, thus offering uniquely deep liquidity. Prices are quite responsive to Fed policy, inflation, and other economic indicators.

CME Eurodollar futures prices are determined by the market’s forecast for the delivery date of the 3-month USDLIBORinterest rate. The futures prices are derived by subtracting that implied annualized interest rate from 100.00. For instance, an anticipated annualized interest rate of 5.00 percent will translate to a futures price of 95.00. On the expiry day of a contract, the contract is valued using the current fixing of 3-month LIBOR.

For example: If you are a buyer of a single 95.00 quoted contract(anticipated future interest rate is 5%), if

at expiration - the interest rate has risen to 6.00%

contract will be quoted at 94.00; the buyer compensates the seller 25¢ on each $100 in the $1,000,000 valued contract. You pay $2,500.

at expiration - the interest rate has fallen to 4.00%

contract will be quoted at 96.00; the seller compensates the buyer 25¢ on each $100 in the $1,000,000 valued contract. You receive $2,500.

The buyer of one Eurodollar future contract agrees on the delivery date to lend 1 million dollars for three months at the annualized interest rate determined now (implied by the trade price). The seller agrees to accept the loan. However, the contracts are settled in cash and no actual transfer of $1,000,000 occurs. The difference between the purchase price and the final settlement price is equivalent to the deficit or excess interest (in cash terms) that would have been paid on the nominal $1,000,000 deposit at the end of the deposit which nominally starts on the delivery date. (i.e. If you buy a contract and the rate increases you lose money because you are making less money than you would have if you agreed the rate on the delivery date.) This interest is calculated as simple interest on a 30/360 basis for three months. So if S is the final settlement price, the interest payment would be: (100-S)/100 x 90/360 x $1,000,000. Thus a change of one price point, or 1% in annualized rate, is equivalent to 1/100 x 1/4 x $1,000,000 = $2,500. Thus the appropriate hedging position can be used to deliver a cash flow that compensates the hedger for the change in interest rates that occurs between the trade date and the settlement date. However, since futures contracts are marked-to-market daily by the clearing house of the exchange these transfers actually occur incrementally through the period between the trade date and the delivery date and not just on the delivery date. The minimum price fluctuation at the CME is 0.005 points (half a basis point) on all delivery months except when a contract is due to deliver within a month, in which case it is 0.0025 points (a quarter of a basis point). These are equivalent to $12.50 and $6.25 per contract respectively.

As with other fixed rate instruments, if the yield rises, the price of the futures contract falls, and vice-versa. If you believe that interest rates will fall, you would then buy a CME Eurodollar futures contract because you expect the contract price to rise (and vice-versa; if you believe rates will rise, you would sell or short-sell a CME Eurodollar futures contract because you expect the contract price to fall). This retains the normal inverse relationship between the price and the yield of interest rate securities. However, the bond convexity is not maintained due to the pricing of the Eurodollar contracts in yield terms.